Advantages & Disadvantages of Closed-End Funds

Closed-end funds trade on the exchanges, with a price that varies with supply and demand

Closed-end funds trade on the exchanges, with a price that varies with supply and demand

A mutual fund gives you access to a large portfolio of shares managed by a professional. This spreads out your risk among multiple investments and largely puts the burden of buy, sell and hold decisions on someone else. If you're researching funds for the first time, there are two basic flavors to consider: open-end and closed-end. While open-end funds create more shares as the public buys in, closed-ends have a limited number of shares. In addition, open-ends are priced at their net asset value, while closed-ends are bought and sold on stock exchanges, with a price that fluctuates with supply and demand.

Asset Value and Pricing

One important advantage that many closed-end funds offer is a price discount. While open-end funds sell at their net asset value (NAV -- the value of fund assets divided by the number of shares), a closed-end fund can sell at either a premium or a discount to the NAV. A common situation in the closed-end world is a fund with $10-a-share assets selling for only $9. The discount or premium on the fund is readily available public information that you can access in financial newspapers or online.

Problem Premiums

Closed-end funds that sell at a premium to their asset value pose a problem for investors. There's no guarantee that a fund's assets will continue to gain in value, and investor optimism -- which is what the premium represents -- can turn quickly. A fall in value toward a zero premium in nearly all cases is going to mean a loss on the investment. Observers in the mutual fund industry usually advise new investors to avoid closed-end funds that trade at a premium. This means there is a strong likelihood that new money won't be coming into the fund and the premium will eventually disappear.

The Management Advantage

A closed-end fund offers certain advantages for managers, who don't have to worry about raising cash for redemptions by shareholders. All of a closed-end fund's shares are issued when the fund initiates operations. Shareholders who want out just put in a sell order, and proceeds of the sale come from the buyer -- not from the fund itself. This gives fund managers more flexibility in their choice of investments and their trading decisions.

Fees and Expenses

Active management, on the other hand, generally means more fees and expenses taken out of the fund. Because the fees are higher, a closed-end fund has a steeper hill to climb to match returns of index funds, which just mirror the performance of market indexes and don't require active management. Shareholders must pay higher fees and must also pay brokerage commissions when they buy and sell closed-end shares. This puts closed-ends at a disadvantage to open-end "no load" mutual funds, which don't charge upfront sales commissions.

About the Author

Founder/president of the innovative reference publisher The Archive LLC, Tom Streissguth has been a self-employed business owner, independent bookseller and freelance author in the school/library market. Holding a bachelor's degree from Yale, Streissguth has published more than 100 works of history, biography, current affairs and geography for young readers.

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